The relationship between financial leverage and profitability Pelican Paper, Inc
ID: 2664704 • Letter: T
Question
The relationship between financial leverage and profitability Pelican Paper, Inc., and Timberland Forest, Inc., are rivals in the manufacture of craft papers. Some financial statement values are for each company follow.Use them in a ratio analysis that compares the firms' financial leverage and profitability.Item Pelican Paper Inc. Timberland Forest Inc.
Total assets $10,000,000 $10,000,000
Total equity (all common) 9,000,000 5,000,000
Total debt 1,000,000 5,000,000
Annual interest 100,000 500,ooo
Total sales $25,000,000 $25,000,000
EBIT 6,250,000 6,250,000
Earnings available for common stockholders 3,690,000 3,450,000
A. Calculate the following debt and coverage ratios for the two companies.
Discuss their financial risk and ability to cover the costs in relation to
each other.
1. Debt Ratio
2. Times interest earned ratio
B. Calculate the following profitability ratios for the two companies. Discuss thier profitability relative to each other.
1. Operating profit Margin
2. Net profit margin
3. Return on total assests
4. Return on common equity
C. In what way has the larger debt of Timberland Forest made it more profitable than Pelican Paper? What are the risks that Timberland's investors undertake when they choose to purchase its stock instead of Pelican's?
Explanation / Answer
Pelican Paper, INC Timberland Forest, INC Debt ratio= Total Debt/Total Asset 10% 50% times Interest Earned Ratio EBIT/Interest 62.5 times 12.5 times Profitability ratios Operating Profit/ sales 25% 25% Net Profit Margin = Earnings available for ordinary shareholders/sales 14.76% 13.80% ROA =Net Profit margin *Total Asset Turnover Ratio 36.90% 34.50% Total Asset Turnover Ratio TOTAL Sales/TOTAL Asset 2.5 2.5 ROE =ROA *FLM 41.00% 69.00% FLM=Total Asset/Common stock Equity 1.11 2 Pelican is more profitbale but Timerland has a higher return on equity due to additional financial leverage risk. Timberlands profits are lower because the interest expense was deducted from EBIT. Also, Timberland has a higher debt, lowering stockholder equity, resulting in a higher return on equity